The importance of investor signaling in venture pricing

Suppose there is a pre-profitable company that is raising venture financing. Simple, classical economic models would predict that although there might be multiple VCs interested in investing, at the end of the financing process the valuation will rise to the clearing price where the demand for the company’s stock equals the supply (amount being issued).

Actual venture financings work nothing like this simple model would predict. In practice, the equilibrium states for venture financings are: 1) significantly oversubscribed at too low a valuation, or 2) significantly undersubscribed at too high a valuation.

Why do venture markets function this way? Pricing in any market is a function of the information available to investors. In the public stock markets, for example, the primary information inputs are “hard metrics” like company financials, industry dynamics, and general economic conditions. What makes venture pricing special is that there are so few hard metrics to rely on, hence one of the primary valuation inputs is what other investors think about the company.

This investor signaling has a huge effect on venture financing dynamics. If Sequoia wants to invest, so will every other investor. If Sequoia gave you seed money before but now doesn’t want to follow on, you’re probably dead.

Part of this is the so-called herd mentality for which VC’s often get ridiculed. But a lot of it is very rational. When you invest in early-stage companies you are forced to rely on very little information. Maybe you’ve used the product and spent a dozen hours with management, but that’s often about it. The signals from other investors who have access to information you don’t is an extremely valuable input.

Smart entrepreneurs manage the investor signaling effect by following rules like:

- Don’t take seed money from big VCs – It doesn’t matter if the big VC invests under a different name or merely provides space and mentoring. If a big VC has any involvement with your company at the seed stage, their posture toward the next round has such strong signaling power that they can kill you and/or control the pricing of the round.

- Don’t try to be clever and get an auction going (and don’t shop your term sheet). If you do, once the price gets to the point where only one investor remains, that investor will look left and right and see no one there and might get cold feet and leave you with no deal at all. Save the auction for when you get acquired or IPO.

- Don’t be perceived as being “on the market” too long. Once you’ve pitched your first investor, the clock starts ticking. Word gets around quickly that you are out raising money. After a month or two, if you don’t have strong interest, you risk being perceived as damaged goods.

- If you get a great investor to lead a follow-on round, expect your existing investors to want to invest pro-rata or more, even if they previously indicated otherwise. This often creates complicated situations because the new investor usually has minimum ownership thresholds (15-20%) and combining this with pro-rata for existing investors usually means raising far more money than the company needs.

Lastly, be very careful not to try to stimulate investor interest by overstating the interest of other investors. It’s a very small community and seed investors talk to each other all the time. If you are perceived to be overstating interest, you can lose credibility very quickly.

http://www.victusspiritus.com/ Mark Essel

Thanks Chris.
Clocks ticking: But I have work to do so it takes precendence over pitching with less to show.
Investor interest: I asked around. No bites yet, that's a signal to me to work harder, smarter, and create a better offer to target users.

I'll build credit with users, site hosts, and people who understand me and the business I need to build. Investors will find me when I'm ready, if I knock on too many doors prematurely it doesn't help my company or myself. When I'm confident we have made something worthy I'll sell/pitch like mad. Luckily, there's a wonderful variety of ways to breathe life into a startup.

I only want to partner with the smartest/likeminded investors, that I believe will see value in what I'm capable of.
http://twitter.com/chriswaldron Chris Waldron

Great post Chris. Another interesting topic I would love to hear more about is getting investments from strategic partners or companies versus a VC.

Where you get money has lots of implications for the future of the company and I'd love to get your perspective.

http://www.cdixon.org chris dixon

That's an interesting and complicated topic. General rule of thumb is you want to take strategic money later (Series B or later) and ideally get multiple strategics so you aren't perceived as beholden to one. I'll put that on my list of future post topics – thx.

http://twitter.com/jordancooper Jordan Cooper

this heard mentality is weak…it is one thing to sit down with Chris Dixon, talk about a company intelligently, and then decide that you agree with his thesis and you'd like to do the deal. It is another to hear that Chris Dixon is doing the deal, and 10 minutes later clamor to get in because Dixon's commitment just made it a hot deal…the thought-leading investors are few and far between, but my advice would be to spend less time trying to manipulate the herd by managing these signals, and more time identifying the real thinkers within it (who are aware of the signals, but make decisions based on their own analysis). if your company is worth financing, signals become a lot less relevant… focus your energy on the thinkers, and the thinkers alone…precision strikes…

http://how2startup.com/ Roy Rodenstein

I'm with ya. Fundraising is a lot like dating, and I've heard Josh K, Mike Maples and others almost espouse the “fundraising at first sight”/they usually know within the first 5 minutes. And when I raised our first round it was the same way, even with two megafund VCs.

Of course, finding an investor that you really feel gets your startup is a luxury not all companies have, so in all cases Chris's tips are valid and well taken.

http://www.rre.com jdrive

As usual, you deftly express a timely, useful guide on a somewhat complex question, and I agree with most all of it. It is worth pointing out, however, that VC's are – as you state – for the most part rational, and therefore unlikely to destroy option value willy-nilly by not funding the next stage of a promising company, without reason. The implicit question is this… 'is a current investor in a better position to assess the relative prospects of a company in which they have invested than someone just exposed to it'? The answer, obviously, is yes. In rare cases externalities might play a role (ie fund end-of-life, partner departure, crazy VC personality disorder [CVC-PD] — you know, the usual things). These tend to get factored out by market intelligence, though.

Generally speaking, it is very much in the VC's self-interest to ride the promising ones – and despite a degree of blogospheric hoopla to the contrary, I know few VC's in today's world that turn down their noses at 'lowly' two or three-baggers. It just means they need to swing harder on the big ones. I would also point out that there exists more than a few angel investors that do, in fact — either directly or through confederates — participate in follow-on rounds in some – but not all – cases. Could it be they know something as well?

http://informationarbitrage.typepad.com/ infoarbitrage

I quite frankly struggle with the issue of VC participation in the seed round. I think so much of it depends upon relationship and the size of fund in question. If Founder Collective or IA Ventures leads a seed round and doesn't lead the Series A, it is to be expected because we both run relatively small funds. However, if RRE participates in the seed and doesn't lead the A, does this queer the deal for everybody? Question is, is RRE's lack of interest in leading due to factors that would come out in the due diligence process anyway, and therefore not alter the ultimate outcome? Or does it really place a damper on others' ability to see value where RRE may not, as RRE is smart money with the wherewithal to rip off a $5 million check for a Series A? I can easily argue both sides.

Bottom line, I think it comes down to relationship. There are larger VCs whom I would invite into a seed round, even knowing the potential risks of what might happen in the Series A. If the VC is great and really adds value during the nascent phase, then it is worth having them at the table because they might lead a Series A at a fair price and with little pain and distraction for the entrepreneur. And if things aren't working out, it isn't their lack of participation that is killing the fund-raising process, it is the company itself.

It is a very hard issue with no clear answer. For the first-time entrepreneur with few deep VC relationships I'd probably avoid large-scale VC participation at the seed stage. However, if there are long-standing relationships with high-quality VCs interested in getting behind the company at the seed stage, I'd seriously consider it. I've seen it work extremely well.

http://www.rre.com jdrive

Can't argue with your conclusions at all; in the end it is always about relationships and trust. Since our 'formal' program is new, we have yet to traverse all the issues, and are openly looking for input(s). We have helped launch several companies out of our offices in the past, however, and I think are of the opinion that the usual step of having a new round 'blessed' by another VC as some sort of conflict-check is not necessarily a prerequisite in these cases; we may lead. I'd rather have the entrepreneurs out building the company, and I assume they would feel the same way. That said, I would also have no problem with them talking to others.
http://www.cdixon.org chris dixon

I agree. I guess I kind of imagine the target audience of my advice to be first time entrepreneurs. E.g. just met some kids who had lots of interest from angels and yet were planning to let a big VC invest $50K. I can't see this as having anything but negative consequences for them.

If, as you say, you are a successful serial entrepreneur, the signaling power of your background will override what some VC decides to do, so you might include them in the seed round if they are helpful.

http://www.victusspiritus.com/ Mark Essel

I'm one of those first timers, appreciate the attention to the signaling issue with getting a bigger VC involved early.

http://www.cdixon.org chris dixon

Thanks Jim. Great comments. Some responses.

“ie fund end-of-life, partner departure, crazy VC personality disorder [CVC-PD] — you know, the usual things… These tend to get factored out by market intelligence, though.”
I think you might be giving market intelligence a bit too much credit. I've been in meetings where entrepreneurs say “X isn't participating but they say it's because they are between funds” and it always sounds a bit fishy. We all know if a VC loves a deal, they'll figure out a way to get some money in it. So one thing I'd worry about taking seed money from a big VC is those kinds of externalities you describe happening.

“Generally speaking, it is very much in the VC's self-interest to ride the promising ones” – I think good VCs (like RRE) think this way and also factor in reputation effects etc when making these decisions. The cases I worry about are with more ruthless VCs and where the company is performing so so (which is probably true of 90% of startups). In this case the whims of the ruthless VC can decide whether the company gets funded instead of more rational, independent market decisions.

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http://www.thesecomefromtrees.com petekazanjy

Add to this the fact that it's important for entrepreneurs to let investors understand that other investors are interested, but not actually reveal *who* has an interest, such that they can't collude to push down valuations, and you get a whole 'nother level of complication.

So you need to abstract “general interest signal” from the actual signal originator, or else you risk buy-side collusion. Of course, if you provide zero information about the identity, then that signal is devalued. It's a mess. There's gotta be a better way to do this ; )

http://www.cdixon.org chris dixon

Yes, this varies by stage. At angel stage, it's ok to mention names if they are truly committed, since angels almost always work together and don't push each other out. At VC stage, you should never mention names, because you are inviting them to collude or do other things to strengthen the signaling effect which works against you.

The best general interest signal is swagger plus setting a fixed time when you are going to be done raising money (“we are wrapping things up in 3 weeks”). VC's are information junkies and quite rationally will always want more information, so as an entrepreneur you need to force things to end. This of course is risky if you get there and don't have any offers. But it's a risky business…

Chris Smith

Interesting that all the advice seem to work in favor of VCs. The message seems to be “don't create any competition for me”

http://www.cdixon.org chris dixon

No, that's not the message. Read the post again if you are planning to raise money. Create competition but just do it in a smart way.

mcenedella

Fantastic post. I love the real world experience explained within the context of economics, and you illuminated some of the very nuanced elements of fund-raising very well.

http://www.cdixon.org chris dixon

Thanks! This came out of my trying to crystalize why vc fundraising feels more like an art than a science – I think the signaling effect is a big reason why.

mdudas

i'm excited that the seed stage funding opportunities for entrepreneurs are growing by the second in terms of options (incubators, individual angels, collectives, etc), resources (seed stage document templates, seed investors blogging about the process) and transparency (bold folks like Chris sharing some of the “insider” psychology, process and the wisdom gleaned through real experience). Great stuff, Chris, and thanks for playing your part!

It would be immensely helpful to see a “Best Practices on Seed Stage Fundraising for the Entrepreneur” post/series on your blog at some point. I'm sure it would draw concepts from many of your previous posts (ie, How Much to Raise in a Seed Round), but it would still be great to see it in one place and learn from the discussion it would generate.
http://twitter.com/davidu David Ulevitch

Getting great investors is just like getting a girlfriend or getting a job – It's orders of magnitude easier when you already have a good one.
http://www.parkparadigm.com parkparadigm

I think most of what you (and Roger and Jim) say here makes a lot of sense (as usual.) And anyone who has been involved in trading any market for any length of time (yes, early stage vc is just another market with another set of assets) knows the old saying that a market is not about picking the prettiest asset but about picking the asset that you think most of the others will think is the prettiest. And so it makes sense to pay attention to what other smart people think when considering an investment.

However, I think that this reality potentially throws up a lot of excellent opportunities for smart, focused investors who are willing to back their own analysis if – after having considered why others see things differently – you still think it stacks up. Of course this can be a lonely place but if you are any good is a great potential source of real alpha: the deals everyone likes are much more likely to be efficiently priced than those who aren't in with the in crowd.

Obviously one should never be contrarian just for the sake of it – especially in this asset class: I suspect 95%+ of the deals that no one likes are probably not good investments. But babies get thrown out with bathwater all the time and having the patience, discipline and conviction to find and back these I think is a great way to generate excess returns. I also think that having a clear domain specialization helps in this context, and is often the key to having the confidence as an investor to swim against the tide.

http://www.cdixon.org chris dixon

Great points. Agree with all of them. I have also observed a few other ways to have an advantage: 1) be perceived as genuinely value-add, so you are given (good) allocations in oversubscribed rounds, 2) act quickly and decisively while other VCs do lots of research. I think of it as spending years to prepare but then being able to decide after one meeting.

http://blog.redfin.com GlennKelman

Another magisterial post Chris.

I tend to think that a series-B deal is the most difficult to raise, and that your caution around the clout of your investors is well-founded. Maybe angel capital is better for that reason. But if you're taking money from any kind of institution whatsoever, it seems like well-capitalized VCs are more likely to support a follow-on round, not less so, just because they have the money. Especially lately, I have seen early-stage investors unable to support a follow-on round because the firm just didn't have the money; it still gives the company a black eye.

And while I generally agree with your advice about avoiding gamesmanship, I know of very few deals done on company-favorable terms that didn't involve competition, often in the form of multiple term sheets. Maybe you don't pursue deals with firms whose money you'd never take, or share terms between firms, but once you have a term sheet, you are probably going to convey to any other interested parties that it's now or never, right?

http://www.cdixon.org chris dixon

Thanks Glenn. I'm definitely *not* arguing against competition. I'm just saying it needs to be done in a delicate way. If VCs feel like they are perceived to be “just money” they can drop out. Also, it is very risky getting the price to the point where there is just one investor remaining, as I describe in the post. Probably optimal is to get to the point where there are a handful remaining and then you choose based on how helpful you think the investor will be.

http://gpm.tecsa.com polit2k

Shop around for a couple of seed merchants one which is credible (track record) but starting up himself. He'll work harder to get your next round at a good price.

http://www.cdixon.org chris dixon

What is a seed merchant?

http://twitter.com/TrophyHubby Trophy Hubby

Great post & superb insights, as always. Could another reason for the inefficiency relate to the absence in the marketplace of third-party, independent advisors? By allowing lead investors to also act as lead advisors (managing the valuation, structuring, marketing, syndication & distribution of a deal), it seems like this practice may lead to further inefficiencies down the road.
Diogenes

Another great post, Chris.

If I were deciding whether or not to follow in another VC's round, I would want to know how the VC does his/her due diligence. To me a VC brand name isn't enough and in fact can be totally misleading. I'd like to get to know that VC's judgement about people and businesses as we all don't get paid for rote analysis, we get paid for having good judgement. Does that VC do his/her own due diligence or does he/she palm it off on an associate? I think it takes a bit of maturity to really hone one's judgement and as smart as some associates are, many lack any real judgement. How does that VC solve problems, as there are always plenty of them? And specifically, how did they make the decision to invest in this particular deal? Or did they follow also?
http://yallaguy.com aarondelcohen

Chris: Is it me or is this the best discussion on your blog ever?

http://www.cdixon.org chris dixon

It's you

http://500hats.typepad.com/ Dave McClure

there are many identifiable metrics for pre-revenue startups that may not be “hard” but are nonetheless verifiable and objective.

however, most VCs don't look at anything beyond:
1) “traffic” (aka unregistered uniques), and
2) money

while often it's the case that there is interesting data to look at, usually investors (or even entrepreneurs) may not be looking in the right places.

http://www.cdixon.org chris dixon

Would love to hear you elaborate on that…

http://500hats.typepad.com/ Dave McClure

well it depends a lot on the specifics of the business, but you can get an idea of what i mean from examples here:
http://www.slideshare.net/dmc500hats/startup-me…

user engagement (time on site), registered emails / users, retention rates, referral rates, and conversion rates from one state to another over time, are all meaningful stats that most investors don't ask about / understand very well…. however they can give a very detailed picture of what's happening with the site that can be quite relevant to making an investment decision.

other issues include whether the product is functional, what user satisfaction data says about how much it's liked, what the competitive alternatives are (and their user sat #s), and whether there is an obvious or non-obvious distribution model or revenue model to figure out, and how close to break-even (cust. acq cost) vs (avg rev per customer) are by channel.

anyway, there's a lot of objective data that can be used to make decisions, if it's being collected & reported. similarly, whether or not the company is iterating on experiments based on collecting the data also says a lot.

hope that's helpful.

http://www.rre.com jdrive

I spend little time early on in a start-up fretting about metrics. In fact, if I am looking at metrics I am more likely to focus in on how good a given team is at predicting things – and whether they get better – than I am at what they actually did.

For me, far more important is how a team thinks about its target market; does it make product decisions based on live feedback? Is it willing to really question direction when new information comes in? Are they fully aware of developments both within and adjacent to their space? In short, flexibility and a willingness to adapt their products and/or services based on what is actually happening as opposed to what one wants to have happen. Now that's a metric.
http://twitter.com/TrophyHubby Trophy Hubby

Great list – agreed 100% on the various metrics.

I'd also add monthly unique user growth, average visits per user per month, eCPMs, sell thru rates, impressions per page, cost per click, CTRs, churn/attrition %, entry/exit rate revenue, rev/FTE headcount, subscription vs adv rev as some other metrics that may be worth considering.

Hope this helps.

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vbd

I love the idea that the initial startup and investor relationship is akin to dating and if things work out they tie the knot. But, the thing that hardly anyone talks about is that the startup/investor marriage ends in a divorce more than 8/10 times.

At the start of the relationship, the investor spends considerable time on due diligence and subsequently sits on the board of the startup to ensure the startup is headed in the right direction. When the startup fails, the usual suspects are to blame the team (ie. the founder CEO or the CEO brought in by the investors), the market or the technology but never the investors who ultimately made the decision to tie the knot and help to guide the startup.

You have to admit, it is a reality-distortion-field at its finest.
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http://twitter.com/rpbatchAEC Bob Batcheler

Responding to Chris Smith who said, “Interesting that all the advice seem to work in favor of VCs. The message seems to be “don't create any competition for me”"….. I don't think that is what this post is saying at all. In my experience, Chris Dixon's advice is totally on the mark. I think the subtext is that rather than an ongoing focus on raising money, entrepreneurs (and their stakeholders) are better served by being singularly focused on delivering value to their customers and building the value of the company. Raising money, and especially overthinking that process, is a HUGE distraction from job #1 – delivering value that customers will gladly pay for….
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Chris Dixon